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Best Buy's "Strategic Investment" Failed

The market pans Best Buy's decision to defend its market share.

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

Disappointing holiday sales results from Best Buy(NYSE:BBY) aren't helping market sentiment this morning, with the S&P 500 and the narrower Dow Jones Industrial Average(DJINDICES:^DJI) down 0.20% and 0.33%, respectively, at 10:15 a.m. EST.

In mid-November, I asked whether Best Buy was gearing up for a battle it can't win. Management at the electronic retailer had just declared it was willing to sacrifice profitability in order to defend the retailer's market share and "win the holiday season." The stock market didn't like the sound of the strategy then and it doesn't like it any better now that Best Buy's holiday revenue numbers are in, showing an 0.9% decline in same-store sales for the nine-week period ended Jan. 4. Shares of Best Buy were down 26% at a.m. EST.

True, Best Buy did more than defend its market share, it took share from rivals including Wal-Mart and Target. However, that doesn't translate into much of a "win." Management now admits that what it calls as a "strategic investment in price competitiveness" came with "a higher-than-expected cost" -- specifically, an estimated decline in fourth-quarter operating profit margin of 1.75-1.85 percentage points, relative to the year-ago quarter. Where is the payoff on this "strategic investment"? Not only is profitability expected to come in lower, but domestic revenue fell 1.5% during the holiday period.

In explaining the revenue decline, CEO Hubert Joly cited several factors, including the intense promotional activity in the industry and "significant store traffic declines between 'Power Week' and Christmas." But as Wedbush Securities analyst Michael Pachter told Bloomberg: "Their initiatives are not driving traffic. They are positioned as if competition will go away, and it won't. The Internet never sleeps." Ouch! Not surprisingly, Pachter has an underperform (i.e., sell) rating on the stock.

On Nov. 19, I concluded my article with the following warning:

Best Buy shares have had a fabulous run this year, as the company came back from what looked like near-death -- they're up 233% even after today's rout. However, that recovery rally may have ended today; Best Buy has survived, all right, but thriving in this environment -- and achieving further stock gains -- is a different matter altogether.

Along with Netflix, Best Buy was one of the best-performing stocks in the S&P 500 last year. However, while Netflix remains a secular growth story, the same cannot be said of Best Buy -- the skepticism I expressed last year is still warranted.